Retirement plan sponsors are continuing to give investment allocations to hedge funds, private equity funds and other alternative investments. However, plan sponsors are no longer focused solely on performance but are also seeking more information on fund operations in order to assess the total risk facing pension assets invested with these funds.
In response, alternative investment managers must ramp up their disclosure of investment and operational risk factors and reassure sponsors about the steps they are taking to control and mitigate risk, according to a new PwC report, Attracting Pension Plan Assets: What Alternative Investment Managers Need to Know.
"In the wake of the financial crisis, pension plan sponsors and other institutional investors are taking a more holistic view of alternative investment funds. They have been attracted by the lower historical volatility, higher returns and varied correlations of these funds, but understand that performance is only half the equation: The other part is risk management, and building trust through greater transparency about the potential risks associated with these investments," says Samuel Gallo, managing director, PwC US’ asset management practice.
This PwC report offers insights on satisfying the transparency demands of institutional investors around risk, increasing trust and attracting new clients. PwC identified nine major areas of risk that alternative investment managers may wish to consider when marketing to plan sponsors and other institutional investors:
Market Risks: Alternative investments involve varying degrees of market risk including equity, interest rate, foreign exchange and commodity risks, each of which can be exacerbated by the use of leverage. Fund managers can satisfy plan sponsor concerns by determining whether the fund’s portfolio risk management systems (e.g., VAR and stress testing) and hedging techniques can detect and mitigate risks.
Liquidity Risk: Exotic instruments or other less-liquid investments used by fund managers may reduce the possibility of a quick exit for investors, especially if multiple investors try to exit a fund at the same time. Some funds are addressing this risk by offering monthly or quarterly investor liquidity after an initial lock-up period, or explaining diversification or stacking strategies that investors can use to mitigate the liquidity risk associated with extended lock-up periods.
Valuation Risk: Investments in instruments such as distressed debt, direct loans, private equity or complex financial derivatives may be hard to value. Fund managers should explain the valuation practices and methodologies they have in place and provide documentation including, if possible, independent, third-party verification of investment values.
Operational Complexity Risk: The inherent complexity of hedge fund operations, with multiple internal and external parties involved in executing strategy, can be magnified if internal controls are inadequate or if there is no effective segregation of duties between those who oversee operations and those who manage the portfolio. Detailing the best practices followed in managing these risks can resolve concerns.
Regulatory Risk: Most hedge and private equity funds are not registered under the Investment Company Act of 1940 and lack the protections associated with mutual funds. To allay concerns, fund managers should communicate with plan sponsors about the oversight and controls to which they are subject, such as ERISA, FATCA or Form PF, and ensure compliance.
Strategy Risk: Active management can lead to deviations from the stated strategy, which creates potential investment planning, diversification and risk control issues for investors. Fund managers are making this less of a concern by imposing rigorous internal controls and expanded transparency to reduce style drift.
Counterparty Risk: Any transaction in which one party must rely on another to complete a transaction exposes an investor to counterparty risk, something which can be magnified by the use of leverage. Effective controls, including position limits or counterparty credit limits, can reduce these risks.
Sub-advisor Risk: Investors have experienced tremendous market volatility, fraudulent investment schemes and increased regulatory scrutiny. Fund managers can address this through a due diligence program that identifies and prioritises emerging trends and risks in sub-advisory relationships.
Vendor Selection: The stability of third-party vendors in providing middle- and back-office services is increasingly critical, since these vendors frequently are instrumental to a manager’s operations. Transparent processes and procedures to evaluate service providers, including sub-vendors, are essential to determining the risk of operational problems or fiduciary infractions.
The PwC report provides specific steps that alternative investment managers should consider each of these risks and communicate their capabilities to help plan sponsors resolve the concerns they may have about investing in alternative funds.
Gallo, who recently was named a 2012 Rising Star of Public Funds at the 11th annual Public Pension Fund Awards for Excellence, says: "The growing popularity of alternative investments among plan sponsors makes this an opportune time for the managers of these funds to reach out to this key investor group. As they do so, fund managers must respond to the increased transparency requirements of institutional investors, especially the information around the mitigation of both investment and operational risk factors."